Signals of Distress

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Which companies will default on bonds this year and next?

While the current turn in the corporate credit cycle resembles the weakening that affected corporate bond issuers in 2001 — at least in terms of the predicted severity — there will likely be some key differences.

Last time around, the industries with the highest default rates heading into the downturn included consumer products, media and entertainment, and forest products and building materials (according to Standard & Poor's). That list is strikingly similar to today's roster of troubled debt issuers, which S&P now measures via a "distress ratio": the number of distressed speculative-grade issues divided by the total speculative-grade issues within a given industry.

In 2001 that list did not include the industry that was about to suffer the biggest meltdown. Telecom saw its default rate reach 10.9 percent in 2001 and 17.8 percent in 2002, accounting for more than half of the $163 billion in corporate bond defaults. The default rate of consumer-products companies, on the other hand, actually dropped.

So, will the distressed-debt monitor help forecast defaults this time around? Craig Peckham, a managing director at Jefferies & Co., believes the monitor is on target. "The last downturn was a corporate-driven recession marked by a material retraction in the levels of capital expenditures," he says. "This will be more of a consumer-driven slowdown" in terms of the industries affected, with homebuilders, forest products and building materials, and retail as likely areas of carnage.

While retail may suffer from the "LBO effect" (balance sheets that carry substantial debt following leveraged buyouts), publicly traded homebuilders may have it worse. Peckham says their over-borrowing combined with over-investment has put them in the same bubble situation that telecom faced in 2001. But, he says, homebuilders' balance sheets remain more fundamentally sound than those of dot-com era telecoms. That may mean that this cycle could, in fact, share something in common with the previous one: the industry suffering the biggest hit may yet come as a surprise.